Liquidity Ratio
Liquidity ratios are one of the most important financial metrics that a company uses to determine its ability to clear its debt obligations towards creditors, without having to raise any amount of external capital. These ratios help to measure a company’s capability to manage its financial obligations. They also determine the margin for safety by calculating metrics that include accounting ratios, like the current ratio, operating cash flow ratio and quick ratio.
One of the most important aspects of the liquidity ratios is that it helps the firms to determine their capacity to convert their assets (both fixed and current) into cash in a quick and cheap manner. These liquidity ratios are extremely useful to the management, as they can be looked at and analysed in a comparative form and method. Their analysis of their organisations’ liquidity situation directs the strategic and tactical decisions. The internal analysis regarding the liquidity ratios focuses on using data from multiple accounting years using the same type of accounting method. It helps when analysts are comparing the previous accounting periods to the present operations, as it allows them to track the changes that have taken place in the business. A higher liquidity ratio is an indication that the company is more than capable of handling the immediate term debt obligations. They can also use the liquidity ratios to inform the investors and promoters about the financial position of the company.
Solvency Ratio
The solvency ratio is one of the most important accounting ratios that is used by companies to determine whether they are able to meet their long term debt obligations without any hassles. It tries to measure the firm’s actual cash flow and not just their net income. To do this, it adds back the depreciation value as well as other non-cash expenses. A solvency ratio is an indicator of whether any enterprise has sufficient cash flow reserves to ensure that they do not default on their loans and at the same time ensure that their financial position stays strong.
Solvency ratios are different from one industry to another. It is, therefore, more prudent to compare the ratio of an enterprise with its competitors from within the industry rather than seeing it in isolation. Doing so will also give an idea about the liquidity position of the company, as well as inform the influence of industry-related factors on an organisation’s ability to pay off its obligations.
Differences between Liquidity Ratio and Solvency Ratio
Although there are major areas of difference between liquidity ratio and solvency ratio, both of them are extremely important to evaluate a company’s ability to handle debt obligations. Some of the major differences between the two are as follows:
Liquidity Ratio | Solvency Ratio |
| Definition |
The liquidity ratio helps to measure a company’s capability to manage its short term financial obligations, and also determine the margin of safety by the calculation of several metrics that include accounting ratios like the current ratio, operating cash flow ratio and quick ratio. | The solvency ratio is one of the most important accounting ratios to determine whether a company is able to meet its long term debt obligations. It tries to measure the firm’s actual cash flow and not just their net income to assess their financial position. |
| Obligation |
The liquidity ratio focuses on the company’s ability to clear its short term debt obligations. | The solvency ratio focuses on the company’s ability to clear its long term debt obligations. |
| Analysis |
The liquidity ratio will help the stakeholders analyse the firm’s ability to convert their assets into cash without much hassle. | The solvency ratio will help the stakeholders analyse the firm’s ability to sustain itself in the industry over the long run. |
| Ratios |
The ratios that help to measure the liquidity are known as liquidity ratios. Some of them are the current ratio, the acid test ratio, the operating cash flow ratio, etc. | The ratios that help ascertain the level of solvency for a business are a part of the solvency ratios. These include the interest coverage ratio, the debt to equity ratio, the fixed asset to net worth ratio, etc. |
| Risk |
Low liquidity can affect the creditworthiness of a business. | High insolvency for a business can also result in bankruptcy. |
Conclusion
It is clear that in spite of several points of difference between liquidity ratio and solvency ratio, both of them are accurate indicators of the financial position of a company. While one ratio focuses on the short term debt, the other lays more emphasis on the long term obligations towards the creditors of a business. The management should focus on the output from these ratios, as it can present a true picture of the liquidity and insolvency position within an organisation.
Frequently Asked Questions
Q1
What is the formula of the interest coverage ratio?
The formula for the interest coverage ratio is as follows:
Interest Coverage Ratio = Earnings before interest and taxes / Interest expenses
Q2
What is the formula of the debt to asset ratio?
The formula for the debt to asset ratio is as follows:
Debt to Asset Ratio = Debt / Assets
Q3
What is the formula of the current ratio?
The formula for the current ratio is as follows:
Current Ratio = Current Assets / Current Liabilities
Q4
What is the formula of the Quick ratio?
The formula for the Quick ratio is as follows:
Quick Ratio = Quick Assets / Current Liabilities
Q5
What is the formula of the fixed asset to net worth ratio?
The formula for the fixed asset to net worth ratio is as follows:
Fixed Asset to Net Worth Ratio = Net Fixed Assets / Net Worth
Also See:
- Change in Profit Sharing Ratio Among the Existing Partners
- Accounting Ratios
- Difference Between Current Ratio and Quick Ratio
- Difference Between Current Ratio and Liquid Ratio
- Advantages and Disadvantages of Ratio Analysis
FAQs
While liquidity ratios focus on a firm's ability to meet short-term obligations, solvency ratios consider a company's long-term financial wellbeing.
What is the difference between solvency ratio and liquidity ratio? ›
The liquidity ratio focuses on the company's ability to clear its short term debt obligations. The solvency ratio focuses on the company's ability to clear its long term debt obligations. The liquidity ratio will help the stakeholders analyse the firm's ability to convert their assets into cash without much hassle.
What is the difference between liquidity and insolvency? ›
Illiquidity is a short-term cash flow issue. The organisation cannot pay today's bills, even though assets still exceed liabilities. Insolvency is a long-term balance sheet issue indicating assets no longer support obligations.
How to calculate liquidity and solvency ratios? ›
To calculate the figure, divide the company's profits (before subtracting any interests and taxes) by its interest payments. The higher the value, the more solvent the company. In other words, it means the day-to-day operations are yielding enough profit to meet its interest payments.
Which of the following statements about liquidity and solvency ratios is correct? ›
Answer. Final answer: The correct statement is that both liquidity ratios and solvency ratios measure a company's ability to meet its financial obligations, with liquidity focusing on short-term and solvency on long-term obligations.
What is the difference between liquidity and solvency Quizlet? ›
What is the difference between solvency and liquidity for a bank? A solvent bank has a positive net worth while a bank with liquidity means that the bank has sufficient reserves and immediately marketable assets to meet withdrawal demands.
What is the difference between solvency and liquidity in finance? ›
Solvency measures how well a company can pay its long-term bills. If the firm has more assets and cash flow than overall debt, it is solvent. Liquidity measures how much cash a company has on hand. If the firm has enough cash and cash-like assets to pay its bills over the next 12 months, it is liquid.
What is the difference between liquidity risk and insolvency risk? ›
Liquidity risk is a short-term situation. Insolvency is the ongoing inability to meet long-term financial obligations. Reducing liquidity risk is about finding the right balance between investing and having enough cash on hand to cover expenses.
How to define solvency? ›
Key Takeaways. Solvency is the ability of a company to meet its long-term debts and other financial obligations. Solvency is one measure of a company's financial health, since it demonstrates a company's ability to manage operations into the foreseeable future.
What is solvency and liquidation? ›
Solvent Liquidation
A Members' Voluntary Liquidation is a legal process to formally wind-up a solvent company's affairs. The company's solvency is defined by its ability to pay its debts in full together with interest within a period of twelve months, from the commencement of the winding-up.
Acceptable solvency ratios vary from industry to industry, but as a general rule of thumb, a solvency ratio of less than 20% or 30% is considered financially healthy. The lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.
What is another name for solvency ratio? ›
Solvency ratios are also known as leverage ratios. It is believed that if a company has a low solvency ratio, it is more at the risk of not being able to fulfil its debt obligation and is likely to default in debt repayment.
What is the solvency ratio? ›
A solvency ratio is a vital metric used to see a business's ability to fulfil long-term debt requirements and is used by prospective business lenders. It shows whether a company's cash flow is good enough to meet its long-term liabilities. It is, therefore, considered to a measure of its financial health.
What is the difference between liquidity and solvency Why does this difference matter to an auditor? ›
Solvency relates to the assets of the company, fairly valued, being equal or exceeding the liabilities of the company. Liquidity relates to the company being able to pay its debt as they become due in the ordinary course of business for a period of 12 months.
Is current ratio solvency or liquidity? ›
Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding. Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.
How to improve solvency ratio? ›
Strategies to Improve Solvency Ratio
- Effective Risk Assessment: Conduct comprehensive risk assessments to identify and evaluate potential risks. ...
- Diversification of Investments: A well-diversified investment portfolio can contribute to a more stable Solvency Ratio.
A solvency ratio is a vital metric used to see a business's ability to fulfil long-term debt requirements and is used by prospective business lenders. It shows whether a company's cash flow is good enough to meet its long-term liabilities. It is, therefore, considered to a measure of its financial health.
What is the difference between solvency ratio and coverage ratio? ›
A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business. This was all about the solvency ratios that determine the solvency of a business organisation by measuring its ability to pay long term debt obligations.
What do you mean by liquidity ratio? ›
Liquidity ratios measure the liquidity of a company. They provide insight into a company's ability to repay its debts and other liabilities out of its liquid assets. Liquidity includes all assets that can be converted into cash quickly and cheaply.
What is an example of liquidity ratio? ›
A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities. A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills.
